Is Rane (Madras) (NSE:RML) A Risky Investment?

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Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies. Rane (Madras) Limited (NSE:RML) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Rane (Madras)

What Is Rane (Madras)'s Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2019 Rane (Madras) had ₹4.18b of debt, an increase on ₹3.59b, over one year. However, it also had ₹178.6m in cash, and so its net debt is ₹4.00b.

A Look At Rane (Madras)'s Liabilities

We can see from the most recent balance sheet that Rane (Madras) had liabilities of ₹5.41b falling due within a year, and liabilities of ₹1.58b due beyond that. Offsetting these obligations, it had cash of ₹178.6m as well as receivables valued at ₹2.49b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹4.32b.

When you consider that this deficiency exceeds the company's ₹3.66b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. Since Rane (Madras) does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Rane (Madras)'s debt to EBITDA ratio (3.31) suggests that it uses debt fairly modestly, its interest cover is very weak, at 1.65. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Investors should also be troubled by the fact that Rane (Madras) saw its EBIT drop by 14% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. When analysing debt levels, the balance sheet is the obvious place to start. But it is Rane (Madras)'s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Rane (Madras) recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On the face of it, Rane (Madras)'s conversion of EBIT to free cash flow left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. And even its level of total liabilities fails to inspire much confidence. After considering the datapoints discussed, we think Rane (Madras) has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Rane (Madras)'s earnings per share history for free.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.